Ethical, sustainable, responsible pays

Two vastly different issues have rocked the corporate world in recent months, highlighting the broad but increasingly important issue of sustainable investing.

The first was the BP Deepwater Horizon oil rig disaster that made the oil giant seek answers for 11 deaths, environmental damage, substandard safety practices and repeated violations of US health and safety laws.

The second issue was the $37 million sexual harassment claim against upmarket retailer
David Jones
and its former chief executive
Mark McInnes
.

As a result of the explosion, BP shares tumbled more than 40 per cent, the company was forced to suspend dividend payments and has promised to put as much as $US20 billion ($22.4 billion) in an escrow account to fund victims of the disaster.

AFR
AFR

While the impact of the sexual harassment case on David Jones’s share price has been nowhere near as severe, chairman
Bob Savage
has acknowledged it could damage the department store chain’s reputation with female customers.

Both issues go to the heart of how companies manage risk in key areas of the environment and social responsibility.

While there is no definitive measure of sustainability within a company, environmental, social and governance (ESG) metrics are increasingly popular as a way to identify sustainable, responsible companies.

Investors do not want a stock in their portfolio with a major issue no one has thought about.

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Hence the need for greater scrutiny of a company’s sustainability principles and the action taken to pursue the company’s sustainability objectives.

What is becoming increasingly clear is that a company’s investment performance does not have to be compromised by a company’s sustainability objectives or an investor’s values.

In many cases performance will be enhanced.

After all, it makes sense that what is good for the environment and the people that a company employs is generally good for a company’s bottom line – and therefore shareholder return.

“By restricting your universe to investments that are looking after people and the planet you are investing in companies likely to do well over the 25 years," Ethinvest managing director Trevor Thomas says.

“There has been that mentality that you have to forgo investment performance [if you invest in sustainable funds]. But I certainly don’t believe that," adds Richard Macdougall, who runs Perennial Investment Partners’ socially responsive shares portfolio.

In theory, sustainable funds should outperform mainstream peers because, as Macdougall says, they are “all about risk minimisation". Sometimes, he notes, that message gets lost.

“It is not ethical investing," he says.

Pablo Berrutti, Perpetual’s manager of responsible investment and sustainability, concurs that it is not just about ethical investing.

“In a quality business sustainability issues are inherent," Berrutti says.

“It is more than just an ethical view. There have to have social, environmental and financial needs in place to be sustainable."

Research conducted for the Responsible Investment Association Australasia found the average return of responsible investment managed funds in the “overseas shares" and “balanced growth" categories outperformed the average mainstream fund in all time periods up to seven years to June 2009.

The accompanying table from Morningstar shows a significant outperformance by a number of the largest ethical, sustainable and responsible investment funds for the year ended June 30.

What makes these funds different are the additional filters in place to pick the companies they invest, in including ESG and sustainability analysis.

In the case of Perpetual’s Ethical SRI fund, which returned 36.71 per cent for the year ended June 30 against the broader market’s 13.2 per cent return, the companies it invests in must first pass four quality filters, identified as sound management, conservative debt, quality of business and recurring earnings.

Its ethical screen means it excludes companies with more than 5 per cent revenue from the production or distribution of products or services in alcohol, gambling, tobacco, uranium, weapons and armaments. Its SRI screen determines whether companies are included or excluded based on their performance in areas such as human rights, environment, occupational health and safety, work and labour standards, animal rights and corporate governance.

Its top 10 holdings include the big four banks, telecoms companies TPG Telecom and Telstra, electrical appliances company Breville, QBE Insurance, health insurer NIB Holdings and consumer products group McPherson’s.

The top holdings in Perennial’s socially responsive shares portfolio, which was established more than 10 years ago, are Westpac Banking Corp, National Australia Bank, Commonwealth Bank of Australia, Origin, Sims, Australia and New Zealand Banking Group, Telstra, biopharmaceutical group CSL, gold miner Newcrest, oil and gas group Woodside and HeartWare International, a medical device company based in the US.

In addition to its own analysis of companies, Perpetual uses the sustainability and governance research produced by the Sustainable Investment Research Institute (SIRIS) in Melbourne.

SIRIS uses a number of criteria to rank Australian, New Zealand and Asian listed companies based on an investor’s view of the world.

Everyone has an opinion of what sustainability is and investor clients will adopt different criteria to meet their investment objectives, says associate director Ben Spruzen.

“There are the values set who look to exclude companies they don’t want to be involved in such as gambling or tobacco," Spruzen says.

“Then there is the value based investor who looks beyond the negative to the positive aspects of a company such as how those companies are responding to environmental and social risks."

The criteria it uses to evaluate a company on the environment include energy consumption and water consumption and carbon emissions.

Social criteria might cover how they treat their employees, their involvement in the community and safety issues.

SIRIS continuously monitors a range of regulatory sites across the Asia-Pacific region for possible breaches by a company including the Environment Protection Authority, domestic and international human rights groups, and corporate regulators such as the Australian Securities and Investments Commission and the ACCC.

It also provides a global context by engaging with leading UN initiatives and other non-government organisations about a company’s behaviour beyond our borders.

“If it is not measured or known we will go to the company and ask. If they do know about an issue and are choosing not to disclose then we need to engage with the company and find out why," says Spruzen.

If you’re concerned about where your money is being invested, what activities the company undertakes both good and bad, how good a corporate citizen it might be and does it see the future in terms of risks it might experience and other such issues that may have financial consequences, then you’d be inclined to look more deeply at and better understand the nature of the company and its operations, says James Their, executive director of Australian Ethical Investment.

“Issues like climate change, how a company treats employees and OHS matters, whether there are supply chain questions and does it produce products likely to benefit from government legislation like renewable energy targets, are all reasons why someone might want to consider items beyond the financial bottom line. Because at the end of the day a company’s reputation is paramount. Just ask BP and David Jones," he says.

Louise O’Halloran, executive director of the Responsible Investment Association Australasia, says there are three main reasons why people want to consider sustainability issues when they invest.

“The first reason is that if you invest in companies with strong governance, a robust culture, good management of people and progressive environmental strategies, then you are much more likely to improve your investment returns," she says.

“Since the global financial crisis and events such as the BP oil spill and Storm Financial, investors have lost trust in the markets and are looking for investment approaches that are more prudent and thorough."

A second reason why people want to invest in sustainable companies, O’Halloran says, is concern about the future of the planet.

“Investors with children or grandchildren often think about the future of the world and how it is going to effect their family members," she says.

And finally, there are those investors who want to invest in line with their values and beliefs, avoiding companies which do harm to people and the environment and supporting those that are trying to make a difference. O’Halloran says a focus on the short term by companies and the funds who invest in them is something that has to change.

“Sustainability becomes incredibly material in a longer time frame," she says.

“Sustainability and governance issues that affect company value are reasonably predictable, and can be taken into account ahead of time through diligent research.

“Unfortunately most issues are discovered at the 11th hour and by then it is too late.

O’Halloran identifies the current key sustainability issues as climate change, resource scarcity including escalating signs of food and water scarcity, energy security, the changing disease and healthcare profile of the world, and the growing market dominance of emerging nations.

“The 21st century is an altogether new world and analysts would do well to understand these big trends and how they are impacting our investments.

“For example, if a company is not ready for a price to be placed on carbon and they have not planned for a transition to a greener economy, then you would expect to see a slow demise in that company’s profitability."

A recent survey of chief executives by Accenture and the UN Global Compact, A new era of sustainability, found the biggest global development issue most critical to address the future success of their business was the failure of education systems, talent pipelines and the capabilities of future leaders to manage sustainability.

Climate change was the second issue, as concern about greenhouse gas emissions continues to grow, followed by resource scarcity (water) and health issues.

Investors are getting better at recognising those companies that are managing environmental, social and governance risks either through existing practices or planned developments.

One way is through the United Nations backed Principles for Responsible Investment Initiative (PRI) which since its inception in 2006 has been working to persuade mainstream investors to better integrate environmental, social and governance issues into valuations and investment processes.

Interestingly, Australia is, by proportions, the largest supporter of the Principles, with over 50 per cent of all funds under management signed and 14 per cent of all worldwide signatories.

.

Importantly those signatories are audited every year to ensure that what they say they are doing is actually happening.

One signatory, investment bank Happily for investors, the amount of information on sustainability issues is rising.

Environmental analysis includes greenhouse gas emissions and water and energy consumption.

Social issues cover the workforce, including turnover, number of women, spending in the community and health and safety policies.

Governance issues include the number of board meetings and attendance, the number of women on the board, and whether there is an ethics policy in place.

Paul Huxford, JPMorgan’s head of equities research Australia, says investors are increasingly looking to incorporate environmental, social and governance principles into the investment process and more Australian listed companies are moving towards reporting ESG data.

The ESG snapshot is an important step to incorporating ESG principles into the investment decision-making process, Huxford says.

“I expect the next decade to be an age of responsibility for capital markets," says Donald MacDonald, chairman of the UN-backed Principles for Responsible Investment Initiative (PRI), which since its inception in 2006 has been working to persuade mainstream investors to better integrate environmental, social and governance issues into valuations and investment processes..

“If a company has poor corporate governance or persists with bad environmental management then it can, and should, affect the long-term valuation of the company," MacDonald says.